Arbitrage and the law of one price in the market for American depository receipts

Alsayed, Hamad and McGroarty, Frank (2012) Arbitrage and the law of one price in the market for American depository receipts.Journal of International Financial Markets Institutions and Money, 22, (5), 1258-1276. (doi:10.1016/j.intfin.2012.07.002).

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Description/Abstract

Ours is the fi?rst paper to highlight pairs trading as the main price-correcting mechanism by which arbitrage can maintain stock-ADR parity. We show that arbitraging stock-ADR pairs extracts small per-trade pro?fits which accumulate to a substantial aggregate return. The observed strong tendency of pricing disequilibria to mean-revert, along with the two-way convertibility between stocks and ADRs, mean that arbitrageurs face minimal risks toward price divergence. They do, however, face uncertainty about the duration of individual trades. The magnitude of this uncertainty relates directly to the profi?t target arbitrageurs set after a long/short position is established. This fact can explain why some disequilibria go unexploited. Overall, our work provides evidence against automatically e?fficient prices, and supports the view that mispricings incentivize arbitrageurs to enforce market efficiency.